by Don Alexander, MBA
Associate, RSD Solutions Inc.
The sudden surge in Italian debt yields raise questions about whether Italy has become a victim of European contagion or are the wounds self-inflicted? This question is raised by Paolo Manasse and Guilio Trigilia in a recent paper Little time for Italy (VOXEU, Manasse & Trigilia, July 19th). The rise in unanticipated risk may prove costly.
The Eurozone crisis now extends to Italy. The authors analyze 5-year credit-default-swaps (CDS) data and reach two conclusions: that Italy’s troubles are home-grown and the default risk is concentrated in the short run.
A number of well known factors contribute to Italy’s vulnerability: large deficits and surging debt levels, low productivity, an aging population and a large corrupt, inefficient bureaucracy. This situation is aggravated by minimal fiscal reforms, a new budget of smoke and mirrors where most spending cuts are not implemented till 2013-2014.
The authors ask three questions: the first question is breaking the CDS spread component into euro-wide and country specific factors to obtain the country’s contribution to a European rather than country specific risks. The findings suggest the Italy’s coefficient is near one indicating that spreads are more closely linked to the Eurozone than being country specific. The second question is how much the euro-dimension explains Italy’s credit-default-swap premium. The findings suggest Italy’s spread variance is less attributable to the euro component and most recently explained by country specific factors as the markets judge Italy on its own merits. Lastly, what is the perceived risk of Italian debt at different time horizons? The authors calculate the hazard rate of default (instantaneous probability) for bonds of different maturities (starting daily in 2007) to see the market view of the timing of the default. The hazard rates are calculated daily for bond maturities of 1-10 years and plotted in a slope. A positive slope means that the default rate is higher in the future. The results show a sharp negative slope indicating the highest risks are concentrated in the short term, especially as the slope turned sharply negative over the last couple of weeks.
The verdict on Italy has not fully emerged yet, but the jury is still out as risks are concentrated in the very short run. Italian leaders such as Mr. Berlusconi and Mr. Tremonti should take note as well as European leaders. Do you have exposure to unanticipated risk?
For more on this story and the work of Mr. Manasse and Mr. Trigilia click on the link: http://tinyurl.com/45yoxmy
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